Island Investing: Status of Reform

A. Last week the Senate passed major financial reform legislation that is in now being reconciled with a bill passed by the House last year. Once the differences are ironed out, it will be signed into law.

The legislation, not without controversy, contains a number of provisions intended to try to reign in banks, set up new regulatory agencies and avoid future taxpayer-funded bailouts. Among other things, the legislation would:

– Create a council of risk regulators tasked with preventing the failures of massive companies which could threaten the entire financial system;

– Establish a consumer protection division for financial products;

– Allow the government in extreme scenarios to seize and close down failing financial companies in order to protect taxpayers from future bailouts;

– Call for a one-time audit of the Federal Reserve;

– Force most derivatives to be traded on exchanges, where regulators will have more transparency and power to oversee them.

On Wall Street, most of the angst revolves around one particular aspect of the proposed reform. The Senate version of the bill directs regulators to restrict banks from proprietary trading – currently a huge source of profits for the banks. Whether or not the banks are forced to spin off, or completely separate from, their derivatives trading business remains to be seen. The Street and its lobbyists appear to be trying quite hard to derail this provision.

In general, the changes in the proposed legislation seem to imply that our financial system was sound, but the credit crisis and Great Recession were caused by a lack of regulation and oversight. As a result, the legislation will reduce the size of the industry’s profits, but will not address the size and/or political power of Wall Street. Read into that whatever you may.

One particular part of the reform that I was particularly glad to see dealt with the credit rating agencies. A system where the banks getting rated pay the firms doing the rating is hard to defend. The end of that practice alone is something to be noted.